4 CONCERNS ABOUT LOW VOLATILITY EQUITIES

Mercer’s guidance for global equity portfolio construction has long recommended investors include an allocation to defensive equity strategies, such as quality-biased equities, low volatility equities or variable beta strategies. Such approaches are expected to offer some downside protection, improve risk-adjusted returns (primarily by lowering risk rather than by increasing returns) and control the overall portfolio beta.

Systematic low volatility equity as a strategy has proved to be a popular option for many investors. However, as a result of a strong run, this approach is now arguably facing a number of challenges. We review four specific concerns — valuation, interest rate sensitivity, crowding and volatility reduction — and provide some broad guidance for investors looking ahead.

WHAT WE RECOMMEND

Mercer continues to recommend an allocation to defensive equities as part of a diversified equity portfolio, with the aim of improving risk-adjusted returns and controlling the overall portfolio beta. Systematic low volatility strategies remain the most straightforward (and lowest cost) approach to gaining this exposure. However, any investment approach has risks, and arguably the risks associated with low volatility equity strategies appear higher now than they were in the past, particularly in relation to current valuations and interest rate sensitivity. We would add that these risks appear greatest in index-based approaches.

Investors with an existing allocation to low volatility strategies, and those considering a new allocation, should be conscious of these risks within the context of their broader portfolio exposures. Aside from choosing an active approach, which affords the investment manager the flexibility to address these risks with thoughtful stock selection, concerned investors could also consider other defensive equity exposures, such as a strategy that can vary its level of exposure to the market or quality-biased equities, to complement their existing investments.

For investors with the governance budget to do so, introducing one of these alternative defensive equity strategies alongside a systematic low volatility allocation could help diversify and may mitigate some of the specific risks associated with low volatility equities in the current environment.

VALUATIONS

Low volatility index valuations have been on a steady upward trajectory since the global financial crisis, and, on certain measures, the index is now trading at a premium to the broader market. This raises the risk of a correction in prices, potentially undermining the supposedly protective nature of a low volatility approach.

Valuations of low volatility securities do appear high compared to recent history and, based on the price-to-book ratio, are also at a significant premium to the broader market, although this is less evident on an earnings basis.

It is less clear, however, whether any relationship exists between relative valuations and the future relative return to low volatility stocks. In other words, are low volatility stocks likely to underperform the broader market given their current high (absolute and relative) valuations?

Download our article, Low Volatility Equities: Time to Leave the Party? to learn more about our guidance on low volatility equities.